On Wall Street, ignorance is not bliss

Another blurb on David Rosenberg of Merrill Lynch, this time from the Globe & Mail in Canada where Rosenberg is from. This one is more about Merrill and its culture than Rosenberg. The paper points out the irony of Rosenberg being the Chief North American economist at one of the hardest hit financial services companies globally.

One year into the credit crunch, mysteries remain. Such as, how did David Rosenberg’s bosses manage to ignore him?

Mr. Rosenberg, a Canadian who was schooled at the University of Toronto, is Merrill Lynch & Co. Inc.’s top North American economist. He was also one of the most voluble people on Wall Street about the great American mortgage disaster. He rang the alarm early, often and loudly. As far back as 2003, he used the word “bubble” to describe excessive lending on overvalued houses. He warned of the potential for deep economic trouble, writing in 2005: “The consequences of even a small decline in home prices could be just as severe as the fallout we saw in stocks back in 2000-2001.”

Mr. Rosenberg was wrong, wrong, and wrong again. House prices and stocks just kept rising. He was wrong for so long that you couldn’t help but question his job security – for what brokerage firm wants to employ an economist who always cries wolf? But then, suddenly, he was dead right, and many of the things he predicted years earlier came to pass. Real estate began to fall, the economy tumbled. Red ink is still cascading through the banking sector.

And which fine Wall Street institution has recorded bigger losses than almost any other, much of it on putrid mortgage securities? Step forward, Merrill Lynch.

If not for the fact that the economic damage makes you want to cry, it would be laughable. No one at Merrill (or Citigroup or CIBC or UBS for that matter) can say they weren’t warned. The binge on credit, the decline of lending standards, the rampant speculation on Miami condominiums and Phoenix McMansions – these things were talked about, written about and debated ad nauseum.

Unlike, say, the failure of Long-Term Capital Management a decade ago, this is not a problem that came out of nowhere. A reckoning was inevitable (though few thought it would be as bad as this, with house prices plummeting an average of 16 per cent across major U.S. cities).

So, getting back to our original question: How is that some of the brightest and best-paid people in finance missed it? “Greed” is a popular answer: When you can destroy tens of billions in shareholder value yet walk away with a $150-million-plus severance that is based on inflated profits from the “good” years, as Merrill’s Stan O’Neal did, that’s a lot of incentive to take risk. But the truth is more complicated. Maybe Wall Street – and Bay Street, to a lesser extent – needs to re-examine its culture.

Shortly before LTCM blew up in 1998, a former Merrill bond guy named Paul Stiles published a memoir of his year at the firm, called Riding the Bull. A couple of reviewers savaged him, and accused him of sour grapes and of whining. Even so, he wrote an entertaining portrait of a dysfunctional workplace where chaos and backstabbing ruled and adult supervision was non-existent.

Mr. Stiles was pushed through six different jobs in a year and, despite his inexperience, was at times given far too much responsibility. “Wall Street must be one of the few places on earth,” he wrote, “where an utter novice can create a highly risky multimillion-dollar product without being subject to any regulatory control – as opposed to the lower-rent areas of Brooklyn, where you can’t fix a toilet without a plumber’s licence.” Hmmm: Sounds like asset-backed commercial paper.

This week, I sat down with a veteran financial guy who recently quit Merrill. The firm he described sounded little different from the one Mr. Stiles wrote of 10 years ago, a place of fiefdoms, disorganization and scattershot decision making. This person’s job was to make bets using Merrill’s money (not day trading, but securities they’d usually hold for a while). When the markets would get rough, and prices would fall, that’s the time to invest. Every good value investor knows that. Instead, Merrill managers would order him to sell. Too “risky,” they’d say.

But even he couldn’t help but marvel how far the company had fallen. Its latest fiasco is auction-rate securities, or ARS. These were not unlike Canadian-made asset-backed commercial paper: Bonds backed by long-term assets, but marketed to investors looking for a secure, short-term investment. When the credit crisis hit, enough new buyers couldn’t be found to ensure the old ones got their cash back. Merrill’s ARS inventory piled up and, according to a lawsuit by the state of Massachusetts, the firm tried to unload it by sugar-coating, or hiding, what was really going on. “Gotta move these microwave ovens!” one Merrill managing director wrote in an internal e-mail. Merrill now must buy back $10-billion in ARS. Citigroup will have to do the same to settle allegations it misled buyers of the securities.

If one thing unites all of these stories, it’s a lack of regard for longer-term consequences – a failure to forgo making a buck now to reduce the risk of losing a lot more later. Why did Merrill buy a subprime mortgage business in late 2006? Because it didn’t look so risky at the time. But as the saying goes, risk is most threatening when it seems least obvious, and least threatening when it seems most obvious. You want to fix the Street’s culture? Make everyone who works there memorize that. And make them read their own economists, too.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.